Oil prices a speculative bubble? Not so fast!

by Peter Pogany, originally published by Energy Bulletin
| Jul 1, 2008

The quadrillion dollar question is, of course, “Why the breathtaking run-up in the price of oil?”

U.S. congressional hearings on the subject and the potentially controversial decision of the International Monetary Fund (IMF) to inspect and scrutinize the U.S. financial sector (blamed in part for the price explosion) reflect grave and growing worldwide concerns.

Oil remains on the front burner this summer.

Analyses and commentaries, virtually in the millions, keep contrasting “market fundamentals” with “speculation” (“real” with “financial” factors). It may be argued that this is a false dichotomy. Much of what is treated as “speculation” ought to be considered among “fundamentals” once we extend this category to include some harsh and unchangeable realities in international monetary and financial affairs.

A statement citing “fundamentals” might read like this: The faster growth of demand than supply (1.1 percent and 0.2 percent, respectively, last year) means that global excess demand for the world economy’s blood plasma (total demand minus total supply) is on the rise. Econ 10: Oil prices must trend upwards.

Explaining this situation with references to “peak oil” and corresponding strategies by big players in the arena (producing-country governments inside and outside of OPEC; major oil companies) and questioning the ability of the market (as structured and legally delineated) still leaves reasoning in the category of “fundamentals.” We are contemplating how and why the interplay of geological givens and market rationality have pushed real (inflation-adjusted) prices to record levels.

Significantly, many analysts concur that even taking into account supply and demand and the not-exactly-global-welfare-serving strategic behavior of oil producers and companies; environmental regulations that prevent or constrain the exploitation of known reserves, and the nefarious effects of civil strife, wars and rumors of war in and around oil-rich countries, the average crude price should be much lower -- somewhere in the vicinity of $80 per barrel. “Anything above that is speculation,” which, let us remember, may have a direct impact on the material oil market. If betting on the long side of futures and options entails significant levels of stockpiling, i.e., withholding oil from immediate delivery, these actions could interfere with actual market conditions.

In the anxious, free-for-all brawl about who speculates and why, and how it is possible for some people to make big money this way while carelessly aggravating the economic misfortune of billions, you may hear about greed and excess, lack of information, stupidity, negligence, and poor risk management; corruption and fraud, deceit and conspiracy; institutions (too permissive, too stifling), not enough regulation, too much regulation; erroneous trade, financial, and monetary policies; lobbies, corporations, and industries; specific individuals (hedge fund managers, bond raters, oil company executives, government officials, current and past), entire countries, blocks of countries, multilateral organizations. There is no place to hide from flying bottles and rotten tomatoes. It is perplexing that there is a kernel of plausibility, if not validity, in every factually presented argument -- a proof of just how complex and confusing the oil issue has become.

It may be time to move the analysis a few notches of abstraction above the fray.

Speculation -- no longer fun and games.

The mere word “speculation” implies voluntary partaking in a gamble; risking a certain amount of money with the expectation of windfall gains. The limo-driven casino high-roller on the Las Vegas strip is the romantically-tinged speculator archetype in popular imagery. But the psychological disposition it implies does not jibe with the main reason why torrents of capital have flowed into oil. The motivation of investment banks, private and public pension funds, equity funds, educational, art, and scientific endowments is not the excitement of raking in luckily-earned chips on the green felt roulette table. No, it is the cold sweat of despair to be burned, being run over, and wiped out by declining asset values -- real estate, stocks, and sub-prime mortgage-infected commercial papers.

In the current context of global inflationary fears, unabated turmoil in financial markets, the weakened dollar, and low U.S. real interest rates, the extraordinary attraction of liquid capital to oil (along with minerals and metals in general, and many agricultural products) becomes readily understandable. It is a defensive strategy, a means of self-preservation.

The division of financial operators into subgroups such as index speculators, momentum players, and traditional “profit and run” types makes sense, of course, from a technical point of view. But most participants in the heterogeneous “speculator community” are united by their perception that the risk of holding dollar-denominated claims is bigger than the risk of holding claims on real resources.

Two inexorably entangled roots have nourished the recent hypertrophic burst in oil prices -- the stubborn disregard of the fundamental message of ecological economics (i.e., our constrained biophysical niche is incompatible with infinite economic expansion) and the simultaneous, but not just coincidental, expiration of post-World-War-II international monetary arrangements.

Asymmetry in the unipolar global monetary order assumes elephantine proportions.

The 1944 Bretton Woods agreement cemented the dollar’s leading role as the global reserve currency, displacing the British Pound. The dollar was put on the same pedestal as pure gold. Eventually, the lien between the two was severed on August 15, 1971.

To the great amazement of those who underestimated the adaptive flexibility of postwar global institutions, dollar hegemony survived without the “barbaric relic.” The world needed money for its growing economy and trade and no other country except the United States could provide it by incurring ever larger external imbalances (linked to internal imbalances) in the process.

In the 1970s, the deal with OPEC to quote crude oil prices in dollars has been critical in maintaining the pivotal role of the U.S. currency. Stepping down from the gold pedestal, the dollar mounted the oil pedestal.

Since the 1980s, the United States has been providing the international economy with the liquidity it needed while becoming the world’s largest debtor country. The swelling quantities of debt instruments have paralleled this evolution.

Continuously growing off-shore dollar balances demanded ever larger volumes of interest-yielding assets. The U.S. financial sector responded to this demand by piling invention upon invention until exuberance began to run riot. Creativity, which deployed enough fantasy to vie with Lewis Carroll’s “Alice in Wonderland,” leaned in increasingly bold and daring ways on the ability of the American public to provide the income flow that domestic and foreign holders of dollar-denominated debt expect.

Flooding the U.S. economy with cheap credit and the consequent rise in real estate values aided this development until the housing boom turned to bust in mid-2007. Declining home prices revealed the incapacity of millions to service their mortgage debt and indirectly, the inability of the “producers” of mortgage-backed securities and a smorgasbord of otherwise securitized obligations to live up to pledges and assurances they gave their buyers. The world’s consolidated balance sheet became contaminated with allowances for uncollectible accounts.

The international economy is now awash in dodgy payment obligations, collectively called derivatives and securitized debt. We are talking here in excess of a quadrillion (thousand trillion) dollars. (2008 Gross World Product is expected to be in the vicinity $60 trillion, of which roughly one fourth is U.S. GDP.) According to the Bank of International Settlements (BIS), this aggregate category comprises around 88 percent of the global monetary mass. An unknown but presumably significant share of it contains expectations that Americans -- deep in debt, with virtually no savings, living with the consequences of declining stock and housing prices, facing job losses, inflation, and credit restrictions -- will generate the cornucopian income streams required to satisfy the holders of these claims strewn from pole to pole across God’s green Earth. One does not have to be a Wall Street wizard to decipher the risk and brewing havoc.

A quadrillion dollars? The mere thought of having to write off only one percent of it gives a new meaning to “shock and awe.”

Not surprisingly, the dollar is on a declining path and any attempt to reverse this trend by raising interest rates and restricting money creation would cause immediate major harm to U.S. output and employment. This impasse flows logically from the unipolar, and, therefore, asymmetric nature of the world’s monetary system.

It’s simple geography. The part is always smaller than the whole and, one way or another, this fact had to find expression in the divergence of advantages and interests, in the development and intensification of potentially disruptive “positive feed-back loops” between the source of a unipolar monetary system and the rest of the planet. (Keynes already saw this at the time of the Bretton Woods conference.)

The world has nowhere to go!

Assertions that the euro is becoming the basis of a new unipolar monetary system neglect the most vital precondition of such a changing of the guard. As long as the dollar dominates worldwide transactions as the medium of exchange and serves as the unit of account (i.e., as the currency of invoice and price reference), it will remain the lingua franca of global commerce.

For the euro to underpin international trade and finance, “euroland” would have to accept the kind of secular deterioration in its current account (assuming flexible exchange rates and unhampered private capital flows) that the United States has experienced during the past half century. Massive balances of euro would need to accumulate outside its domestic economic playground and immediate vicinity to support trade between South Korea and Peru; Malaysia and Iceland. And by now everybody who is willing to look can see: Seigniorage translated into becoming the world’s biggest consumer is no piece of cake. It has a dark side. Deindustrialization, the creation of bubbles, fiscal deficits, and loss of national control over economic destiny seem to be par for the course. It is hard to imagine how and why the EU could be cajoled or forced into following such a road.

Crisis of world financial institutions and oil price hikes are linked.

For decades, offshore dollar balances greased the wheels of global industry and commerce by facilitating the expansion of domestic money supplies and economic relations. The dollar became the international currency backed by world production and later by assets as capital account liberalization gathered momentum in the post-Cold War era.

With the strengthening grip of physical constraints on economic expansion (expressed also through environmental regulations and political pressure for ecological sanity), the new millennium saw a decline in the value of dollar-denominated interest-bearing instruments. Most importantly, an additional unit of oil became dearer to the world at large than an additional dollar. Other major currencies and gold -- not directly linked to oil -- also appreciated against the dollar.

To recap the mega narrative behind the big picture: Growth in world economic output, dependent on dollars, ran into physical limits -- good-bye forever cheap oil! But the structure acquired by the world economy is such that increasing dollar balances keep spewing into the system, adding more and more to the stock of dollar-denominated obligations.

The system, which allowed America to specialize in consumption and dissaving -- mirroring industrialization and the accumulation of savings in the rest world -- continues to act like a wheezing old mechanism that has not been turned off. U.S. external imbalance keeps growing, adding to dollar-denominated promises already sufficient to paper over the Great Wall of China.

Untenable “positive feed-back loops” in complex systems erupt through seemingly random, unrelated, and unexpected developments. The cyclical contraction of the U.S. real estate market is such a development in global finances. It has cast doubt on the solvency of the world’s largest private investment and banking institutions, exposing reliance on one nation’s money to ensure international liquidity as a fantastically primitive, if not weird, idea.

Now the dollar is everybody’s money and everybody’s problem.

Although possibilities for random, seemingly unrelated, and unexpected sources of disruption multiply until the breakdown of untenable systems becomes practical certainty, a case can be made that the U.S. real estate bubble had to be “it.” Commercial papers based on mortgages represent the largest class of financial instruments that can be produced without the consent or knowledge of the ultimate debtor -- including the millions of American families now groaning under the weight of negative home equities.

Speculative capital flows as survival reflex and signal amplifier.

The U.S. financial sector, including its banking industry, cannot be separated from the historical role the United States has played since the end of World War II.

First it maximized profits while the postwar system -- predicated on limitless economic growth -- worked; now it tries to minimize its losses (survive) as natural constraints begin to remind the planet’s surging population about the absurdity of transforming the planet into one sparkling shopping mall (with ample parking for all).

It is important to recognize that market forces prompted the U. S. financial/banking sector in both its offensive (profit maximization) and its current, defensive (loss minimization) phases. Suppressing the flow of capital into oil trade now would kill the messenger of bad news to no avail. It could temporarily bring down oil prices by substituting one economic growth disabling factor for another.

Beyond weeding out ridiculous excesses and unfairness, closing loopholes in reporting obligations, and intensifying the criminalization of insider deals or conspiratorial profiteering, the U.S. government ought not to adopt a strategy of excluding non-directly related capital flows from oil and other natural resource markets.

High oil prices may turn into the sobering, merciless catalyst the world needs to shift its economy toward renewable resources.

Consumer civilization is the ultimate bubble, the extrication of individual desires for growing material comfort from the Earth’s intrinsic ability to support billions -- and then even additional billions yet to join us -- addicted to scurrying around on four wheels to do some more shopping. All other bubbles are mere epiphenomena of this fundamental misreading.

Therefore, “peak conventional oil/peak conventional dollar” is only a symptom, and, what has become known as “speculative oil price bubble” is only a symptom of a symptom. But it still conveys valuable information. It is an immune system-like reaction of market forces in the broadest sense -- telling society about its error and pointing toward the solution.

There is green in the world’s future and a new beginning for the greenback.

Educated in Eastern Europe and in the United States, Peter Pogany is an economist. He taught at the college-level for ten years. During the Cold War, Peter was contributing editor to the East-West Trade Report, a U.S. Congress-mandated quarterly on trade with communist-controlled countries. His overseas experience includes economic research positions in Europe and Africa and a teaching assignment in Asia. With an unquenchable appetite for history, philosophy, the natural sciences, and languages, he describes himself as "an eternal student."

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